Can you have too much income from dividends?
Long-time readers of this site know I take a two-pronged approach to investing. I own a number of Canadian dividend paying stocks for income (and long-term growth) (about 30 in all) however I also own a few U.S. dividend paying stocks for income, growth and a couple of low-cost U.S.-listed ETFs for greater diversification. You can read about those holdings including what I put where in more detail here and here.
As a follow-up this article on my site about having a fat RRSP to deal with I got a detailed reader response that arrived at this question:
Can you have too much income from dividends?
Today’s post will explore some answers to this question and of course, since this is my blog, I will offer a take on this subject as it relates to my own investing journey.
First of all, let’s be clear what a dividend is and what is not. Here is one of the slides I presented during a Canadian MoneySaver webinar with my partners from 5iResearch some time ago:
When a corporation declares a dividend, the company’s retained earnings decrease and its current liabilities increase. When the cash dividend is paid, the corporation’s cash account decreases. Dividend payments directly reduce a company’s earnings, so only stable, well-established companies tend to make regular dividend payments.
Why would companies pay dividends at all?
Great question actually. Companies use dividends to pass on their profits directly to shareholders. They don’t have to but many companies do. Why? A few reasons come to mind for me:
- Reason #1 – it is core to company strategy. Potentially there are no current companies to acquire, maybe company debt is under control, and/or there is already a healthy stream of cash to begin funding new company products or services. Thus, as part of company strategy to reward shareholders – the board of directors feels it’s simply one of the best things to do with company profits over time.
- Reason #2 – the company is on sound financial ground. Most companies that pay a dividend, especially long-term (as in decades) have a stable business model. You really can’t fake dividend payments for very long. Companies that grow their dividend tend to have great cash flow – profits. As an investor, it’s to your advantage to own shares in a company that makes large profits, consistently, with time. A reliable dividend is essentially one very good sign of business strength. This is because unstable companies cannot divert profits directly to shareholders for very long.
- Reason #3 – they want to attract investors. This is akin to company strategy. Some investors are more speculative and like risks (note: this is not me). Dividend-paying companies can attract a certain type of investor; one who prefers cash in hand versus the hope of capital gains. Such investors like the idea of earning income from their investments the same way people go to work to earn an income – it’s dependable. Over time the work is performed by their portfolio. The portfolio will pay out MORE income over time if you reinvest dividends and/or you hold such dividend paying companies long enough whereby dividends are increased by the company every year or so. Companies know there are investors out there who put a bias on income generated from their portfolio over growth.
- Reason #4 – companies know investors like optionality. You see, in a perfect world, all businesses would allocate capital in a way to perfectly maximize the return on that capital. This would be done so reinvested money would go back into the business in way that pays off immensely for the shareholder (by increasing returns over time AND by continually reducing the company’s tax burden). But you should know by now we don’t live in a perfect world. This means shareholders have over time demanded a dividend – for the purposes of “optionality”. That old link I provided above tells us shareholders like optionality – and dividends provide that optionality – to give investors the choice to increase or decrease their exposure to the business. Reinvested dividends therefore, take advantage of that optionality, to increase exposure. Dividends taken as cash, do not.
Dividends are therefore one very important part of an investor’s total return. An investor could technically create their own dividend (income stream) by timing the sale of their stock shares during times of market jubilance, leveraging stock price appreciation. This may or may not appeal to some investors.
So, to the question, can you have too much income from dividends?
My answer is: probably but that’s a great problem to have.
Let me explain.
While I believe there are great merits in owning a collection of dividend paying stocks for passive income I can see a few downsides.
- Lack of diversification, home bias. If you’re only investing in Canada, or the U.S.,via dividend paying stocks, you might be missing out on the benefits of diversification over time – since not all companies, sectors, nor do countries move in lock-step when it comes to market returns. This means diversification can assist investors through risk management – investors do not need to rely on any part of the market let alone any one market to fuel portfolio returns.
- Taxable income. While Canadian dividend paying stocks are rather tax-efficient they may not be as efficient as capital gains – depending on your earned income. In a taxable account Canadian dividend paying stocks are eligible for a dividend tax credit from our government. This means taxation on dividends are favourable, it is a lower form of tax; lower than employment income and interest income. Other assets, especially those that only apply to capital gains, may be even more favourably taxed. Here is a table from one of the sites I visit frequently for tax information (no affiliation) taxtips.ca:
In my province (Ontario) you can see that, assuming I have no other taxable income to report (e.g., employment income, pension income, interest from investments, etc.) I could theoretically earn about $50,000 per year in dividend income and pay no tax! (hint: look at the “Canadian Dividends – Eligible” column for the marginal tax rate for earned income levels.)
Other income sources
With no specific advantage that comes with dividend investing (over any other form of investing) I believe an investor should therefore consider how to generate a healthy, diverse mix of income to cover their expenses. Here are some income sources my wife and I will rely on in our financial future:
- Workplace benefits – pensions
My wife and I are both very fortunate to have some workplace pensions to draw from in our future.
Very conservatively, I anticipate my defined benefit pension pre-tax income will be more than $20,000 per year starting at age 60. That plan has some inflation built in as an added benefit. I anticipate my wife’s pension will be less, but again, conservatively, I suspect her defined contribution pension income will be $15,000 pre-tax per year starting at the same age. This won’t be enough to retire on so we’ll need other income sources.
- Personal benefits – working in retirement?
My wife knows I never plan to retire in the traditional sense. I will work as long as I’m physically and mentally able to, into my 60s, 70s and beyond. This is my plan now. Things can and may change. I anticipate I could earn up to $10,000 per year pre-tax working at something; throughout my 60s and potentially into my 70s.
- Registered Retirement Savings Plan (RRSP) withdrawals
While I don’t believe you should fully trust all the big bank financial ads – you are not always richer than you think thanks to the laws of inflation and taxation at work – you probably don’t need millions of dollars saved inside your RRSP to retire modestly.
Taxtips also has a great RRSP & RRIF drawdown calculator to play with. In doing so you can see a solid RRSP portfolio valued at $500,000, at a more traditional retirement age of 65, can deliver a solid income stream for a few decades – almost 30-years in fact using the values I put into the table. You can insert your own numbers and play out your scenarios.
My wife and I are confident if we can maximize contributions to our RRSPs going-forward we should be able to earn close to $30,000 per year pre-tax from our portfolio starting in our 60s.
- Government benefits – CPP and OAS
Contrary to what many Canadians think, our Canada Pension Plan (CPP) is well-funded for the next 50-75 years, maybe more. So, Canadians who have lived in Canada and have worked in Canada for the better part of their careers should expect some income from CPP.
CPP benefits are adjusted once a year, in January, based on changes over a 12-month period related to the Consumer Price Index (CPI) – the cost-of-living measure used by Statistics Canada.
Old Age Security (OAS) benefits are also based on the CPI, but are reviewed and revised quarterly.
Given both CPP and OAS government benefits include some inflation protection (via CPI), I personally consider CPP and OAS very bond-like. For this reason, I have a tilt towards equities in our personal portfolio and likely always will. I’m not sure when I will/we will take CPP or OAS. It will depend. As we get closer to determining our income needs we’ll figure it out. Conservatively, I would think most 60-somethings who have worked in Canada and lived in Canada for most of their lives should expect to earn about $1,000 pre-tax from CPP and OAS combined. That’s a decent rule of thumb for your calculations.
What am I getting at?
Looking at the inventory above, I believe we are building towards generating a diverse income stream to fund future wants and needs – income earned via dividend paying stocks are just part of that equation. Absolutely, to the reader’s question, you could have too much income earned from dividends (to trigger a tax headache in retirement). Yet considering all the other issues that may come with aging gracefully I believe having a tax small problem in retirement is likely one the best problems to ever have.
What’s your take? Can you have too much income from dividends? Why or why not?
Happy New Year to all readers!!